Loan types
Loan modification – is the lower payment worth it?
If you’re like an increasingly large number of Americans, you’ve recently received a letter from your bank. And if you’re lucky, it’s not a notice of foreclosure--it’s a letter announcing an offer for a loan modification. The banks are handing these things out like candy these days, and most people, especially those with banks that already have a tendency to try to upsell to their customers, are suspicious.
A lot of these loan modifications include options to switch an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, partial debt forgiveness, and other bells and whistles. And, while the banks are not doing this out of some sudden bout of philanthropy, many unsolicited loan modifications are a good deal for both parties. Before we continue, never ever assume that all loan modification offers come from reputable sources because most are paid advertisements. There are scammers out there that will take you for all your worth if you aren’t vigilant. Real loan modification offers should come from the bank that handles your mortgage.
Banks are trying to get ARM loans out of their systems--they’re far more likely to end in default than fixed-rate loans and the government views them as “toxic assets”, which in turn can affect how the government and investors deal with the banks. In short, a farewell to ARMs is a hello to more money for the bank.
If you’re still waiting for the catch, here it is: loan modification affects your credit. (Not in a good way.) A lot of loan mod customers don’t realize that until it’s far, far too late. As a rule, avoid loan modifications unless you can live with a hit to your credit score. The question becomes: are lower or more consistent mortgage payments more important than good credit? If the answer is no, you may be better off looking at refinancing, or just staying in the mortgage you already have. If the answer is yes then you would be better off reading some of our other articles about short sales or foreclosure.
There are, of course, ways to solve the problem of loan mod credit pain. Be sure you discuss the terms of the loan modification with your bank before you sign. Banks can report the loan mod in several different ways to credit bureaus, which will have various effects on your credit. Have banks explain how they’re going to report the loan mod, and avoid “trial periods”. Part Two of this post will explain exactly what’s going on under the hood, and how you can get a loan modification that will not destroy your credit.
Next Step
Loan Modification - credit killer!
In Part One of our loan modification post, we discussed the fact that banks are sending unsolicited offers of loan modification to mortgage holders. These deals, which often involve a change from adjustable-rate mortgages (ARMs) to fixed-rates or partial “principal forgiveness” make a lot of sense from a purely economic standpoint: the banks get to clear their books of “toxic assets” and you get a lower mortgage payment. Unfortunately, the results can ding (or even wreck) your credit score.
There are a number of reasons why this is the case. First, the bank reports activity on your account to credit bureaus, which then alter your credit score accordingly. If you modify your loan and the bank submits “settled for less than the full amount due” to a credit bureau, that’s going to hurt you. And while this is technically true, a tiny line item leaves out the important information that it was, in fact, the bank that suggested the modification in the first place. To avoid this, make sure you ask specifically how the bank is going to report the change. If they don’t give you a straight answer right away, be clear that you’re trying to avoid “settled for less than the full amount due”.
Further, if the loan modification requires a trial period, especially one that lowers your mortgage payment, that trial period can damage your credit, as the bank will have to report the payment as less than what you owed, even though it’s the amount of money the bank is expecting, and will not respond to the customer as if anything were out of order.
The loan modification can also have tax repercussions, as any reduction in principal is treated as income by the IRS. If you’re already making a reasonable amount, an increase in taxes can be a real pain. In the worst case scenario, you may end up being unable to pay off this tax, and back taxes are (not surprisingly) a hit to your credit.
Thankfully, you have options. We’ve already said it, but again: ask your bank about the terms of your loan modification. Ask them how it will be reported to credit bureaus. Beyond that, you can avoid the tax problem through the Mortgage Forgiveness Debt Relief Act, which exempts you from taxes stemming from loan mods on your primary home. The act is good until 2012.
The bottom line? Always know what you’re getting into.
Next Step
View Larger Map